NPV vs IRR

NPV Method

Calculate NPV in terms of currency. Then express IRR in terms of the percentagereturn a firm expects the capital project to return. Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not.

IRR Method

The IRR Method cannot be used to evaluate projects where there are changing cash flows . For example, an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm. However, the IRR Method does have one significant advantage. Managers tend to better understand the concept of returns stated in percentages. They find it easy to compare to the required cost of capital.

NPV vs IRR Comparison

While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows. This is preferable to a larger project that will generate more cash. Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation.

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Bailout Payback Method

Real Options Approach

The Real Options Approach allows for flexibility and encourages constant reassessment based on the riskiness of the project’s cash flows. It is also based on the concept of creating a list of value-maximizing options to choose projects from. In fact, management can, and is encouraged, to react to changes that might affect the assumptions that were made about each project being considered prior to its commencement, including postponing the project if necessary. It is also noteworthy that there is not a lot of support for this method among financial managers at this time.

One Response to NPV vs IRR

The fundamental premise of your statement (Key differences between the most popular methods, the NPV (Net Present Value) Method and IRR (Internal Rate of Return) Method) is wrong in the sense that NPV and IRR are the product of the same method (DCF) using the input data (NCF) and IRR can be derived from the NPV (NPV = 0 at IRR). The arguments are not valid and I am in the process of publishing analytical evidence to prove some of the conventional wisdoms (NPV vs IRR).